What Would Paul Krugman Do?

President of the European Central Bank Jean-Claude Trichet and Federal Reserve Chairman Ben Bernanke at Jackson Hole (Photo: Reed Saxon/AP)

President of the European Central Bank Jean-Claude Trichet and Federal Reserve Chairman Ben Bernanke at Jackson Hole (Photo: Reed Saxon/AP)

WWPKD? Much more than Ben Bernanke has done. In a recent New York Times op-ed, Krugman criticizes the Federal Reserve chairman following his much-anticipated Jackson Hole announcement for not doing enough to reduce unemployment and foster economic growth. But he spares Bernanke his strongest criticism, which he reserves for the “political intimidation” that has caused Bernanke to back away from what he regards as more sensible Fed policies. So would Krugman do? What Bernanke proposed for Japan in 2000. Krugman writes that “we learn a lot by asking why Ben Bernanke 2011 isn’t taking the advice of Ben Bernanke 2000.” He refers to a paper Bernanke wrote that Krugman thinks was “on the right track”—“as well I should,” he discloses, “since his paper was partly based on my own earlier work.” So here are Krugman’s proposals for what the Fed should do:

• Announce “that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates”.

• Announce “that the bank was seeking moderate inflation, ‘setting a target in the 3-4% range for inflation, to be maintained for a number of years,’ which would encourage borrowing and discourage people from hoarding cash”.

• Depreciate the U.S. dollar, which is to say, to devalue it in terms of other currencies.

But hasn’t the Fed already done these things? Well, pretty much, Krugman admits. And, he admits, it hasn’t brought recovery. But, he insists, that’s not because they are bad ideas, it’s just because Bernanke wasn’t radical enough about implementing them. Krugman acknowledges, “Last year, the Fed actually did institute a policy of buying long-term debt, generally known as ‘quantitative easing’ (don’t ask).” In fact, the Fed has already instituted two rounds of “quantitative easing”, or “QE”, dubbed QE1 and QE2. Krugman is calling for QE3, but thinks Bernanke isn’t going to do it because he feels intimidated by opponents of QE.

It’s telling that Krugman urges his readers not to ask about “quantitative easing”. Former Fed Chairman Alan Greenspan once admitted that he engaged in “Fedspeak” to leave his listeners (e.g., members of Congress) completely befuddled about what he had just said. That’s not to say Fedspeak such as “quantitative easing” is never meaningful. Actually, in this case, it means pretty much what it says. The root of “quantitative” being “quantity”, it is the term given to the Fed’s purchase of U.S. Treasury bonds or other government securities, which increases the base money supply; that is, it increases the quantity of money in circulation, which in Keynesian economic theory is supposed to “ease” the pain of a hurting economy (for reasons we will return to).

It’s not as confusing as it sounds, and if you understand what “quantitative easing” really means, you will understand why you are not supposed to ask. Essentially, Treasury securities are I.O.U.’s—promises to pay at a future date the principle amount borrowed plus interest. They represent U.S. debt. So the Treasury issues these I.O.U.’s to buyers, including the Federal Reserve (which is not really federal at all, but is a system of for-profit privately owned banks that pays its stockholders an annual 6% dividend). In return for these I.O.U.’s, the Fed loans the government money. Where does it get this money that it loans out at interest to the government? Why, it simply creates it out of thin air! POOF! Neat magic trick, huh? The printing presses are turned on, and the fiat currency in the form of Federal Reserve Notes—that is, “dollars”—is created.

So these paper notes, which we think of as “money”, are spent into the economy and deposited in various banks across the country. And then comes the even neater magic trick of fractional-reserve banking. When you deposit your “money” in the bank, the bank then loans it out to others, with a requirement only to keep a certain “reserve” in the bank—say 10%—to give to depositors who wish to withdraw their “money” from their account. This is possible because usually less than 10% is ever withdrawn at any one time. In other words, the bank doesn’t actually have everyone’s deposits of “money” in its vault, which is why it is problematic if too many people wish to withdraw too much of their “money” at one time, which is called a run on the banks.

So if $10,000 in hard currency is deposited into bank A, it can then loan out $9,000, keeping $1,000 in reserve. Now say the borrower goes and spends that $9,000 to make a purchase, and the seller deposits his earnings in bank B, so that bank can now loan out $8,100, keeping $900 in reserve. The new borrower buys something and the new seller deposits the cash in bank C, which then loans out $7,290, keeping $810 in reserve. And so on.

Except that banks don’t really loan currency that way. That is to say, banks don’t really loan out their deposits of Federal Reserve Notes, but instead issue loans by expanding the money supply. Say that same $10,000 in hard currency is deposited into bank A, but this time, the bank doesn’t just loan out $9,000, keeping $1,000 in reserve. Rather, the $10,000 in deposits is the reserve from which the bank can then loan out an additional $90,000. It is still meeting its requirement to keep 10% in reserve. So if the deposits don’t account for the loans, where does that loaned “money” come from? Why, it is simply created out of thin air! The bank punches some keys on a computer and—POOF!—extra digits show up on a borrower’s account statement. Neat trick, huh? That’s the magic of fractional-reserve banking.

The bank hasn’t turned on some printing press and created more Federal Reserve Notes to place in its vault to represent the amount of the loan, the $90,000. The “credit” was just signed into existence when the borrower put his John Hancock on the loan agreement. So the “money” that was “borrowed” never existed in the first place. But the borrower can still go buy a car or a house or whatever, because the seller will accept those digital numbers being transferred to his or her own account as value for the item sold. Works great, doesn’t it? Well, sure, except that the borrower now owes the principal plusinterest on the “money” the bank “loaned” him by creating it out of thin air, and, of course, if he doesn’t repay it, the bank will take the house he bought with the “money” he borrowed—which is to say, in either case, that the borrower must repay something of real value representing the fruit of his labor in return for having borrowed something of no real value representing no labor or production. But, hey, that’s fair because that’s what he agreed to when he signed his name to that contract. A deal is a deal.

So this is how most “money” comes into existence. Through the inflationary magic of fractional-reserve banking, the money supply is increased. And when a borrower repays his or her loan, it decreases the total money supply. That is, paying off debt is deflationary. Those digital numbers representing the principal return to the place from whence they came. Created out of nothing, they return to nothing. And then there is the interest…. Federal Reserve Notes actually account for only a small fraction of all the “money” that is transferred through the economy day to day.

Returning to “quantitative easing”, it is just another name for the expansion of the money supply. It is the monetization of U.S. debt. Every Federal Reserve Note in existence represents debt. To pay off that debt, every single Federal Reserve Note would have to be repaid to the Fed, which is to say every single paper dollar—each having been borrowed into existence in the first place—would have to be removed from circulation to pay the principle on Fed’s loan to the government.

Ah, but then there is the interest on that debt. If the total base money supply (that is, all the hard currency in the form of Federal Reserve Notes) is required to pay off the principal, where does the interest come from? Why, it has to be created into existence, too! That is done through the Fed “purchasing” more Treasury securities (it’s usually said the Fed “buys” securities, but what that really means is that the Fed is making a loan to the government at interest). Thus, the Federal Reserve monetary system requires that the U.S. government never be able to pay off its debt. (In fact, the only time the government has ever completely paid off its debt was during the presidency of Andrew Jackson, who killed the Second Bank of the United States, an early forerunner to the Federal Reserve modeled after the Bank of England.) When you hear the term “debt monetization”, it means just that: turning U.S. government debt into a supply of “money”. Under this system, money is debt.

The Federal Reserve monetary system not only requires that the government never be able to pay off its debt, but also that the money supply be steadily increased over time in order to create the “money” for borrowers to be able to repay the principle plus interest on their loans. That is why the Federal Reserve sets a target rate of steady inflation. Ever wonder why your grandparents could talk of paying 10 cents for a loaf of bread? Well, there you have it. Money is subject to the law of supply and demand like any other commodity. The more dollars there are in circulation, the less each dollar is actually worth. As a consequence, in order to stay profitable, businesses must raise their prices. So if a loaf of bread cost $0.10 in 1930, today the same loaf of broad would cost $1.35. One dollar in 1913—the year the Federal Reserve was created—was worth more than $22 in terms of 2011 dollars. The U.S. dollar has lost over 95% of its purchasing power since the Federal Reserve Act of 1913.

So you can begin to see why Krugman says to his readers, “don’t ask” about “quantitative easing”. It requires a little bit of explaining—too much to really cover in a New York Times op-ed—and you aren’t really supposed to know anyway (hence the existence of “Fedspeak” and other gibberish invented by economists to obfuscate how things really work).

So, to summarize, when Krugman prescribes QE3 as part of the solution to the U.S.’s economic troubles, what he is saying is that the U.S. government should borrow more money into existence (or, as he puts it, the Fed should make “purchases of long-term government debt”). This, Krugman argues, would “push interest rates, and hence private borrowing costs, down”. Naturally, if you borrow money, you want to get the lowest interest rate possible. So does the U.S. government. When U.S. securities are perceived as being a safe investment, purchasers of U.S. debt are willing to accept a low rate of return. Low risk, low return. If perceptions change, and Treasury securities are seen as riskier investments—for fear, say, that the U.S. government will not be able to make good on its debt, but might default—then they will want a bigger return on their investment, and thus the interest paid on securities rises. Higher risk, higher return. All Federal Reserve Notes come into existence through the monetization of debt. But when the Fed monetizes the debt for the purposes of pushing interest rates artificially low and creating economic “stimulus” during a crisis or recession, then it is known as “quantitative easing”. Same thing, different name.

So the prescription here includes the Federal Reserve manipulating interest rates, pushing them artificially lower than they would be if they were determined by the free market. This is also a manipulation of perception, creating the illusion of investor confidence in U.S. Treasury securities. When the government borrows at a low interest rate and that debt is monetized, it translates, as Krugman notes, into lower rates of interest on private borrowing (that is, the borrowing by private citizens of the “money” supply that was created from debt monetization and deposited in banks across the country). The point of this, of course, as Krugman says, is to encourage more people to borrow more money. That is to say, the purpose is to incentivize people to go into debt, or get further into debt. The incentive of artificially low interest rates played no small part in the housing bubble that led to the financial crisis in 2008.

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The mainstream media provide information within a very narrow framework that serves to manufacture consent for government policies and stifle meaningful debate on important issues.I provide analysis and commentary from outside the standard framework, challenging mainstream narratives, exposing government and media propaganda, and broadening the scope of the discussion.I'm an independent political analyst, publisher and editor of Foreign Policy Journal, and author. My new book is Obstacle to Peace: The US Role in the Israeli-Palestinian Conflict. Read the entire first chapter for free at ObstacleToPeace.com. Find me on the web at JeremyRHammond.com.